imgbd Advisor Speak

Why can't we admit the truth for once?

S K Bagaria, Mentor ASK Circle, Kolkata

23rd January 2017

In a nutshell

The issue of commissions causing conflict of interest and the regulator's continuous efforts to tinker with regulations around this, is now 8 years old. Bagariaji says its time for us to first admit the truth - that there does exist a conflict of interest situation. He shares a very interesting perspective on the actual source of this conflict of interest, and from there, leads to an alternative solution that can potentially address the conflict of interest issue while protecting business viability of distributors. On the issue of empowering the investor to decide intermediaries fees, Bagariaji makes an important point - if the regulator has the confidence in the maturity of the investor, let the investor decide total fees he will pay - including fund management fee. If we think that level of maturity is not yet there, let the regulator regulate both - fund management fee as well as distributor commissions. Half way house is not a solution.

Conflict of interest is the root of our problems

Our regulator has been consistently and explicitly voicing a concern that there is conflict of interest in the present commissions set up - and that conflict of interest results in distributors often being guided by commission levels rather than product suitability, in making fund recommendations to investors. This concern has persisted since 2008, and we have seen progressive regulations, each one aimed to trying to curb this conflict of interest. It started with ban on entry loads, then went on to commission caps, then onto enhanced commission disclosures and now finally, a proposal that basically tells distributors that if you want to make recommendations, earn a fee from your investor for it, but if you want to remain a distributor, stop making any recommendations of any kind.

We continue to be in denial mode

Our response has consistently been one of denial - denial that conflict of interest exists. Therefore by extension, denial that investor's interests are not being served as well as they should. So long as we remain in denial, we will have more and more of such regulations coming our way. Our remaining in denial is now at a stage where we are almost going to give up everything, if the proposed RIA regulations are enforced in the manner currently envisaged.

I believe if we want a practical solution, we have to be practical first. We have to first honestly acknowledge that there is indeed a problem, and then make honest attempts at offering genuinely workable solutions.

Regulator too has to accept a reality

That's as far as we distributors are concerned. The regulator too, in my view, has to adopt a consistent approach. In this whole effort to empower the investor to decide how much he wants to pay to his advisor, our regulator is omitting one aspect. Today, out of the cost an investor pays for a mutual fund, the larger proportion goes to the AMC as fund management fees, then the second largest portion goes to the distributor and the residual goes to R&T agents, custodians etc. If you want to empower an investor, please empower him to determine how much he wants to pay for all - for the fund manager, for his advisor and for support services. Don't discriminate by saying that one aspect of what he pays will remain regulated where the investor is not empowered, while in the other aspect, the investor will be empowered. That is inconsistent and discriminatory.

If somehow the industry believes it is impractical for fund management fees to be mutually decided by fund houses with every investor, distributors feel likewise about negotiating for every transaction with every client, and then recovering the negotiated fee every quarter.

So what therefore is the practical way forward?

I believe the best way forward is for SEBI to regulate both aspects - fund management fees as well as distribution commissions. Since when SEBI came into being, they have regulated TER - the amount charged by the fund house to the investor. There is a cap put on this - and the cap is the same for all fund houses. Fund houses are free to charge less than the cap, but cost pressures ensure that they keep it at the ceiling for equity funds, while it is lower than the cap for debt funds. You don't find too much difference between expense ratios across funds within the same size bands.

TER fungibility is at the root of conflict of interest

Until 2012, there were also restrictions on how much of the TER can be allocated to which type of expense. This coupled with ban on entry loads, resulted in a sharp drop in commission payouts. Then came fungibility, which allowed AMCs to spend total TER any which way they wanted. Fungibility is the root cause of all the commission distortions we are seeing in the market, and the root cause of conflict of interest. To put it plainly, AMCs' unhealthy competition on commission payouts is what induces distributors to divert their attention from client interest to self interest.

SEBI should regulate TER and commissions separately

The simple solution is for SEBI to regulate separately TER for fund houses and commissions for intermediaries. Let SEBI put a cap on maximum commission that any distributor can be paid - and this can be linked to size of investment, to recognize effort involved in sourcing small transactions. When SEBI regulates commissions and these slabs are common across all fund houses (like TER), there is no conflict of interest. And, let the entire regulated distributor remuneration be in trail format only. This is in my view, the only way we can actually tackle conflict of interest and yet preserve viable business models.

To conclude

If SEBI has confidence in the maturity of our investors, let them fully empower them to decide what they will pay to all parties involved in managing their investments. If that level of confidence is not there, then regulate all components. When you leave one component unregulated (commissions) and empower fund houses to do what they please with fungible TERs, you create a problem. And then you come down heavily on distributors and talk about empowering the investor to decide how much he wants to pay to his distributor/advisor. This myopic view must go. Distributors must recognize that there is indeed a conflict of interest situation, and must voluntarily suggest to the regulator to regulate their commissions and make them uniform, to eliminate conflict of interest. Else, we will stand to lose everything. The choice is ours to make.

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